New York, NY – Yesterday’s blog called The End of the Independent Era struck a chord for many indie research providers prompting concerned calls asking if we thought that the independent research industry was dead. We need to be clear that Integrity Research DOES NOT think independent research firms will go away anytime soon, nor do we think that IRPs need to become broker-dealers or registered investment advisers to address their clients’ fears about the safety of using their research. However, we do think that just producing great research is no longer enough to convince buy-side investors to purchase their service. Now all independent research firms (not just expert networks or channel check providers) need to add formal compliance policies, procedures, and personnel to protect their buy-side clients — much like registered broker-dealers have provided for decades.
Why Are Asset Managers Responding?
As we have written in the past, asset managers’ fears about using independent research has risen as a result of the federal insider trading investigation. Some of the buy-side firms that have implemented the most rigorous vetting procedures for their research have done so to mitigate headline risk and to limit potential legal and regulatory actions from impacting the entire enterprise. However some clients are pushing IRPs on compliance for another more important reason. One recent example might help put this into perspective.
A few months ago we met with an executive at a large pension fund. In the midst of our conversation they explained that after the news about the federal insider trading investigation hit the headlines in November, they called all of their external asset managers to see if they were using expert networks and how they were managing their use of them.
During these interviews, it became clear to the pension fund that even if their hedge fund managers did not use expert networks, they had introduced considerable risk into their research process based on the other types of research they used, including channel checkers, industry consultants, lobbyists, former government officials, etc. This realization prompted the pension fund to start asking existing and potential fund managers to explain their risk management process around the use of external research. We suspect this pension fund isn’t the only one who has started asking their hedge fund managers these questions.
While a handful of asset managers previously realized the risk of using external research and have implemented procedures to identify and mitigate this risk, others have more recently started to address these issues because of growing requests from their large institutional customers.
What Should Indies Do?
If the world has changed so much that great research alone is not enough for the buy-side, what should an independent research firm do? We think there are a few viable options.
- Create an institutional infrastructure. The most obvious way for an independent research firm to address buy-side client concerns about the safety of their research is to develop an institutional quality compliance infrastructure. This means hiring a knowledgeable third-party like an attorney or other compliance specialist to develop appropriate compliance policies and procedures to address the topics that are of primary concern to clients. This includes information control issues like confidential information, MNPI, and potential bribery concerns. This also requires finding someone in-house or bringing in a new member of the team who can handle the responsibilities of Chief Compliance Officer to oversee the day-to-day fulfillment of these compliance policies. A large number of independent research firms, including expert networks and channel check providers have invested a great deal in this area in order to mitigate their clients’ fears about the safety of the research they produce.
- Partner with those who already have one. Another way some independent research firms are addressing these buy-side compliance concerns is by partnering with firms that already have an institutional compliance infrastructure. For example, some buy-side firms have noted that an affiliation between an IRP and a registered broker-dealer could assuage their fears. Of course, this would really only work if the B/D were willing to actively take on a significant portion of the compliance oversight of the affiliated research provider. While a large number of B/Ds market independent research to their buy-side clients, we only know of a few agency brokers who are willing to take on the legal and regulatory risk of providing proactive compliance oversight of their affiliated research providers.
- Become a registered entity. While we do not think most independent research firms need to take on the added expense and regulatory oversight, some firms may decide that it makes business sense for them to become registered broker-dealers or RIAs. We must note that most buy-side clients we have spoken with do not think that becoming an RIA is sufficient to address their compliance concerns. We also should warn IRPs that we have seen as many compliance problems for regulated entities as we have for independent research providers. Certainly, we DO NOT BELIEVE it makes sense for an IRP to become a B/D just to deal with clients’ fears about the safety of the firm’s research. After doing the analysis ourselves, it is clear to us that independent research providers can spend much less to address client concerns than the $60,000 to $100,000 in startup costs, plus the significant ongoing expenses required to support a B/D with a formal compliance platform.
- Get objective third-party verification. Regardless of whether the independent research firm develops internal policies and procedures; partners with a firm that can provide these services; or becomes a registered entity themselves, we think it might make sense for them to get objective third-party verification of their compliance platform. The two ways IRPs can accomplish this is either by hiring an external law firm or by engaging a firm that specializes in these issues like Integrity Research to conduct a review of your compliance policies, procedures, and practices. Research providers we have spoken with that have taken this step have used these external reviews to improve their internal compliance practices, and as a marketing tool to convince clients and prospects that they have adopted industry best practices with their compliance infrastructure.
A Double Edged Sword
The buy-side’s growing requirement that ALL their research providers have compliance controls in place to address the risk inherent in their research processes could be seen as a double edged sword. On the one hand, developing and implementing these policies and procedures are both costly and outside the core competencies of most IRPs. On the other hand, establishing these controls not only addresses the compliance concerns of buy-side clients, but it also raises competitive barriers for new research providers as the cost of entry has gone up.
In addition, IRPs that have invested a significant amount in building great compliance platforms can use these as important features of their service which can be marketed to new and existing clients. Gerson Lehrman Group is one IRP that has been doing this for quite a few years. However, the comprehensiveness of their compliance offering has increasingly resonated with buy-side clients over the past year enabling them to pick up market share in a shrinking market.
As we mentioned in yesterday’s blog, we believe that over the past few years the independent research industry has undergone a fundamental change. A few years ago regulators and clients were most interested in limiting conflicts of interest within the research industry – a trend that benefited independent research providers. Today, information control has become the hot button topic leading clients to focus on research providers’ compliance controls and practices – a development that benefits sell-side research firms. However, this does not mean that independent research firms cannot succeed in this new reality. Instead, IRPs that produce great value-added insight also need to make sure they address this changing market requirement and implement an institutional quality compliance framework to protect their customers.